Jeff Pierce's  Instablog

By Chris Ebert

Option Index Summary

Why is it that stock prices sometimes go up one day and down the next, without any significant news event in the market that would explain the two moves?

How is it possible that stock prices sometimes go up when there is bad news, and down when there is good news?

Just who or what is it that is making the market behave the way it does?

Some may conclude that "evil" bankers are the cause, or some sort of covert government influence is at work. Others would consider those to be outlandish ideas. But it truly does not make a difference - good and evil are irrelevant when it comes to understanding how the stock market works. An evil Wall Street tycoon or a benevolent trader of a retirement account are both slaves to the emotions of greed and fear. And since greed is really just the fear of missing out, the only emotion that matters is fear; and fear affects all humans, both good and evil.

When Franklin Roosevelt spoke his famous phrase "The only thing we have to fear is fear itself", he probably did not have the stock market in mind. But that little bit of wisdom can be a great benefit for a trader who is attempting to gain an understanding of the market. Fear is what trading is all about.

There are lots of ways to measure the effects of fear. Most technical indicators are actually fear gauges. Perhaps the most common of these is the VIX, the so-called fear index. But the VIX tends to only measure fear once it is present.

Many times, once fear has increased it is already too late to take action. The scenario usually involves a drop in stock prices that make up a broad index such as the S&P500. When prices fall, fear increases and the VIX usually rises. In this scenario the VIX isn't indicating anything traders don't already know. They know prices have fallen, they know traders are fearful of further declines, they probably are fearful themselves.

So how can we anticipate fear? In other words, how do we know when to "fear" fear itself. While the VIX has serious limitations in this regard, there are many other technical indicators that can be of value. From simple plots of resistance and support levels, to more complex analysis such as the Relative Strength Index, Fibonacci levels or Elliot Waves, the intent is the same - to not only gauge fear, but to anticipate it.

The performance of stock options can also be used to determine when fear should be feared. This type of analysis can be used either as a standalone tool, or in combination with other technical indicators. The Long Straddle/Strange Index (LSSI) is often an effective indicator of the fear of fear. While the LSSI is not yet shouting "Fear is near!" it is holding up a warning sign this week.

Long straddles and long strangles on the S&P500 (using an ETF such as SPY) are types of option trades that rarely produce a profit. When they do earn a profit, it is time to pay attention because it is a signal that the market is beginning to do something unusual. The LSSI tracks the performance of these trades, so a positive LSSI is a reason to pay attention.

This week the LSSI rose to a level that is very near to turning positive. The last two times this occurred were in April 2012 and September 2012; and each was followed by a significant correction that lasted several weeks. It does not necessarily mean that a correction is imminent here in February 2013, but it does mean that fear is definitely something to be feared now.

If the S&P rises much further from its current level in the low 1500s, a correction will become more likely. At levels above 1580 a correction would be almost certain. For now, the market is bullish and strong and fear is low. But fear of fear is now prudent. An in-depth reasoning behind this conclusion may be found below, in a simple three-step process:

STEP 1: Are the Bulls in control of the market?

The performance of Covered Calls and Naked Puts reveals whether the Bulls are in control. The Covered Call/Naked Put Index (CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

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This week, covered call trading and naked put trading were both profitable, as they have been for anextended period. That means the Bulls remain in control. The reasoning goes as follows:

• "If I can sell an at-the-money covered call or a naked put and make a profit, then prices have either been going up, or have not fallen significantly." Either way, it's a Bull market.
• "If I can't collect enough of a premium on a covered call or naked put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control." It's a Bear market.

STEP 2: How strong are the Bulls?

The performance of Long Calls and Married Puts reveals whether bullish traders' confidence is strong or weak. The Long Call/Married Put Index (LCMPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

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This week, long call trading and married put trading were both profitable. Both forms of trading became profitable in late January. It means the Bulls are not only in control now, but they are confident and strong. The reasoning goes as follows:

• "If I can pay the premium on an at-the-money long call or a married put and still manage to earn a profit, then prices have been going up - and going up quickly." The Bulls are not just in control, but they are showing their strength.
• "If I pay the premium on a long call or a married put and fail to earn a profit, then prices have either gone down, or have not risen significantly." Either way, if the Bulls are in control they are not showing their strength.

STEP 3: Have the Bulls overstepped their authority?

The performance of Long Straddles and Strangles reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range. The Long Straddle/Strangle Index (LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

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This week, long straddle trading and long strangle trading were both very near to returning profits. While technically, they were losing trades, the losses were very small, and that is a significant change over the past several weeks. It means the Bulls have not yet overstepped their authority, but they are getting mighty close. There is still room for the market to move higher before it will become due for a correction, but it is not necessary for the market to move higher for a correction to occur. It could happen tomorrow, or it could happen if the S&P climbs another 50 points or more. It is also possible that the market could move sideways for a while, without any significant correction at all. The reasoning goes as follows:

• "If I can pay the premium, not just on an at-the-money call, but also on an at-the-money put and still manage to earn a profit, then prices have not only been going up quickly, but have gone up surprisingly fast." Profits warrant concern that the market may be becoming over-extended, but generally profits of less than 4% do not indicate an immediate threat of a correction.
• "If I can pay both premiums and earn a profit of more than 4%, then the pace of the uptrend has been ridiculous and unsustainable." No matter how much strength the Bulls have, they have pushed the market too far, too fast, and it needs to correct

Conclusion

The bulls retained control of the market this week. They also gained more strength this week, so much so that they are in danger of overstepping their authority if they continue to push stock prices higher. The S&P still has a little room to move higher, but not above 1580, at least not in the next few weeks. The same goes for the Dow, it still can go higher, but not to 14,600. Such large rallies, when combined with recent gains, would likely result in a significant correction. It is also possible that a correction may occur at any time now, without the market making gains first.

Option position returns are extrapolated from historical data that, while reliable, cannot be guaranteed accurate. It is not possible to match the exact performances shown, because the strike prices and expiration dates used in the calculations will not always be available in actual trading. All data is relative to the S&P 500 index.

The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book "Show Me Your Options!"